Can you provide summary notes …
Based on Chapter 1, "Core Concepts of a Risk-Based Approach to Conducting a Quality Audit,"
here are summary notes with illustration samples:
Chapter 1: Core Concepts of a Risk-Based Approach to
Conducting a Quality Audit
I. Nature of Independent Financial Statements Audit
● Auditing Defined: A systematic process where a competent, independent person
objectively obtains and evaluates evidence about economic actions and events to determine
the correspondence between assertions and established criteria, then communicates the
results to interested users.
● Purpose of an Audit: To enhance the confidence of intended users in financial
statements by expressing an auditor's opinion on whether the financial statements are
prepared, in all material respects, in accordance with an applicable financial reporting
framework.
○ This opinion typically addresses whether financial statements are presented fairly, in
all material respects, within the framework.
● Assurance Engagement: An audit of financial statements is an assurance engagement
as defined in the Philippine Framework for Assurance Engagements.
II. Overall Objectives of the Independent Auditor (PSA 200)
● Primary Objectives:
○ To obtain reasonable assurance that the financial statements as a whole are free
from material misstatement, whether due to fraud or error. This enables the auditor to
express an opinion on their preparation in accordance with an applicable financial
reporting framework.
○ To report on the financial statements and communicate as required by the PSAs,
based on the auditor's findings.
III. Ethical Requirements Relating to an Audit of Financial Statements
● Auditors must comply with relevant ethical requirements, typically Parts A and B of the
Code of Ethics for Professional Accountants in the Philippines (Ethics Code).
● The engagement team can generally rely on the firm's quality control systems for ethical
compliance, unless contradictory information arises.
● Firms are required to establish policies and procedures to ensure compliance with ethical
requirements by the firm and its personnel.
IV. Conduct of an Audit of Financial Statements
● Audits should be conducted in accordance with Philippine Standards on Auditing (PSAs).
● PSAs contain basic principles, essential procedures, and related guidance.
● Philippine Auditing Practice Statements (PAPSs) provide interpretive guidance and
practical
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● Auditors may also conduct audits in accordance with both ISAs and PSAs; currently, there
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are no fundamental differences between IAASB pronouncements and AASC requirements.
to edit at the same time.
V. Scope of an Audit of Financial Statements
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● Definition: Refers to the audit procedures deemed necessary to achieve the audit
objective.
● Auditors must comply with all relevant PSAs.
● In exceptional circumstances, an auditor may depart from a basic principle or essential
procedure if necessary to achieve the audit objective, provided the departure is documented
per PSA 230.
VI. Professional Skepticism
● Auditors must plan and perform audits with an attitude of professional skepticism,
recognizing that material misstatements may exist.
● Meaning: A critical assessment with a questioning mind of audit evidence, being alert to
contradictory evidence or unreliable information from management.
● Importance: Reduces the risk of overlooking unusual circumstances, overgeneralizing
conclusions, and using faulty assumptions.
● Management representations are not a substitute for sufficient appropriate audit evidence.
VII. Reasonable Assurance
● Auditors obtain reasonable assurance that financial statements are free from material
misstatement.
● Concept: Relates to accumulating sufficient audit evidence to conclude that no material
misstatements exist in the financial statements as a whole.
● Limitations: Absolute assurance is not attainable due to inherent limitations of an audit:
○ Use of testing.
○ Inherent limitations of internal control (e.g., management override, collusion).
○ Most audit evidence is persuasive, not conclusive.
○ Auditor judgment in gathering and evaluating evidence.
○ Other limitations affecting persuasiveness of evidence for particular assertions (e.g.,
related party transactions).
● An audit opinion does not guarantee future viability or management
efficiency/effectiveness.
VIII. Audit Risk and Materiality
● Audit Risk: The risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated.
● Objective: Auditors should plan and perform the audit to reduce audit risk to an
acceptably low level.
● Achieved by designing and performing audit procedures to obtain sufficient appropriate
audit evidence.
IX. Responsibility for the Financial Statements
● Management (with oversight from those charged with governance) is responsible for
preparing and presenting financial statements in accordance with the applicable financial
reporting framework.
● The audit does not relieve management or governance of their responsibilities.
X. The Risk-Based Audit Process
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● Risk-Based Audit Approach: Begins by assessing the types and likelihood of
misstatements in account balances and adjusts the amount and type of audit work
accordingly.
○ Views organizational activities in terms of risks to strategies and objectives, and
management's plans to mitigate those risks.
● Account-Based Audit: An approach where the auditor understands and assesses control
risk for specific types of errors and frauds in particular accounts and cycles.
● Stages of the Risk-Based Audit Process (under PSAs):
○ Phase I: Risk Assessment
■ Preliminary engagement activities (acceptance/continuance).
■ Planning the audit (overall strategy and plan development).
■ Performing risk assessment procedures (identifying/assessing risk of material
misstatement by understanding the entity).
○ Phase II: Risk Response
■ Designing overall responses and further audit procedures to address
assessed risks.
■ Implementing responses to reduce audit risk to an acceptably low level.
○ Phase III: Reporting
■ Evaluating audit evidence to determine if additional work is needed.
■ Forming an opinion and preparing the auditor's report.
Illustration Sample: Figure 1-1: Describing the Three Elements
RISK ASSESSMENT RISK RESPONSE REPORTING
What events* could occur that Did the events* identified occur What audit opinion, based on
would cause a material and result in a material the evidence obtained, is
misstatement in the financial misstatement in the financial appropriate on the financial
statements? statements? statements?
*An "event" is simply a business or fraud risk factor that, if it actually occurred, would adversely
affect the entity's ability to achieve its objective of preparing financial statements that do not
contain material misstatements resulting from error and fraud. This would also include risks
resulting from the absence of internal control to mitigate the potential for material misstatements in
the financial statements.
Illustration Sample: Figure 1-2: Risk-Based Audit Process (Schematic)
(This is a detailed flowchart, but the key phases and their activities are summarized above and in
the table below)
Phase Activity Purpose Documentation
I Perform preliminary Decide whether to Listing of risk factors;
engagement activities accept engagement independence;
engagement letter
Plan the audit Develop an overall Materiality; Audit team
audit strategy and audit discussions; Overall
plan audit strategy
Perform risk Identify/assess RMM Business and fraud risk
assessment procedures through understanding (including significant
the entity risks);
Design/Implementation
of relevant internal
controls; Assessed
RMM at F/S Level and
Assertion level
II Design overall Develop appropriate Update of overall
responses and further responses to the strategy; Overall
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audit procedures assessed RMM responses; Audit plan
that links assessed
RMM to further audit
procedures
Implement responses Reduce audit risk to an Work performed; Audit
to assessed RMM acceptably low level findings
III Evaluate the audit Determine what New/revised risk factors
evidence obtained additional audit work (if and audit procedures;
any) is required Changes in materiality;
Communications on
audit findings;
Conclusions on audit
procedures performed
Prepare the Auditor's Form an opinion based Significant decisions;
report on audit findings; Signed audit opinion
Signed audit opinion
XI. Relevant Philippine Standards on Auditing (PSAs) in the Risk-Based
Audit Process
● The document lists specific PSAs applicable to different aspects of the audit process,
including:
○ Guidance on Fundamental Concepts: PSA 200 (Overall Objectives), PSA 220
(Quality Control), PSA 315 (Management Assertions), PSA 500 (Audit Evidence), PSA
230 (Audit Documentation).
○ Phase I - Risk Assessment: PSA 210 (Client Acceptance), PSA 240 (Considering
Fraud), PSA 250 (Consideration of Laws and Regulations), PSA 300 (Planning an
Audit), PSA 315 (Assessing RMM), PSA 320 (Materiality), PSA 330 (Responses to
Assessed Risks), PSA 550 (Related Parties).
○ Phase II - Risk Response: PSA 260 (Communication with Governance), PSA 330
(Responses to Assessed Risks), PSA 530 (Audit Sampling), PSA 250 (Laws and
Regulations), PSA 500 (Audit Evidence), PSA 501 (Audit Evidence Specific
Considerations), PSA 505 (External Confirmations), PSA 540 (Auditing Accounting
Estimates), PSA 520 (Analytical Procedures), PSA 620 (Using an Auditor's Expert).
○ Phase III - Reporting: PSA 250 (Noncompliance with Laws and Regulations), PSA
450 (Evaluating Misstatements), PSA 560 (Subsequent Events), PSA 550 (Related
Parties), PSA 570 (Going Concern), PSA 580 (Written Representations), PSA 260
(Communication with Governance), PSA 700 (Forming an Opinion), PSA 705
(Modifications to Opinion), PSA 706 (Emphasis of Matter), PSA 800 (Special
Considerations - Financial Statements Prepared in Accordance with Special Purpose
Frameworks), PSA 805 (Special Considerations - Audits of Single Financial
Statements).
XII. Understanding the Audit Risk Model
● Nature of Risk: Uncertainty about events/outcomes that could materially affect the
organization.
● Four Critical Components of Risk Relevant to Auditing:
1. Audit Risk (AR): Risk that an auditor gives an unqualified opinion on materially
misstated financial statements.
2. Engagement Risk: Economic risk that a CPA firm is exposed to (e.g., litigation,
reputation damage) by associating with a particular client.
3. Financial Reporting Risk: Risks related to the recording of transactions and
presentation of financial data.
4. Business Risk: Risks affecting operations and potential outcomes of organizational
activities.
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● Audit Risk Model Formula: AR = IR \times CR \times DR
○ Inherent Risk (IR): The susceptibility of a transaction or accounting adjustment to
be recorded in error or not recorded, in the absence of internal controls.
○ Control Risk (CR): The risk that the client's internal control system will fail to
prevent or detect a misstatement.
○ Detection Risk (DR): The risk that the audit procedures will fail to detect a material
misstatement.
● Factors to Consider in Implementing the Audit Risk Model:
1. High-risk activities: Events where material misstatement could easily occur (e.g.,
high-value inventory, complex accounting systems).
2. Existence of large non-routine transactions: Significant related party
transactions, unusual volume, major sales/supply contracts, business segment
purchases/sales.
3. Matters requiring judgment or management intervention: Assumptions and
calculations in estimates, complex accounting principles, revenue recognition subject
to differing interpretation.
4. Potential for fraud: Risk of not detecting material misstatement from fraud is
higher than error. Auditors consider perpetrator's skillfulness, size of amount, level of
authority, and significant fraud risks identified during the audit.
Illustration Sample: Quantitative Example of Audit Risk
● Case I: High Risk of Material Misstatement
○ XYZ Mining Corporation has high inherent and control risk (set at maximum, 1.0
each) due to complex transactions and weak internal control.
○ Auditors set audit risk (AR) at 0.01 (1%).
○ Calculation of Detection Risk (DR): DR = AR / (IR \times CR) DR = 0.01 / (1.0 \times
1.0) DR = 0.01 or 1\%
○ Result: Low detection risk means the auditor cannot rely on internal control and
needs extended audit work.
● Case II: Low Risk of Material Misstatement
○ Zoren Trading Corporation has low inherent risk (0.50) and control risk (0.20) due to
simple transactions, well-trained accounting personnel, and effective internal control.
○ Audit risk is consistent with a low engagement risk (e.g., 0.05).
○ Calculation of Detection Risk (DR): DR = AR / (IR \times CR) DR = 0.05 / (0.50
\times 0.20) DR = 0.05 / 0.10 DR = 0.50 or 50\%
○ Result: Higher detection risk indicates less need for extensive substantive tests, as
controls are effective.
XIII. Limitations of the Audit Risk Model
● Inherent risk is difficult to formally assess.
● The model treats each risk component as separate and independent, but they are not.
● Audit risk is judgmentally determined.
● Audit technology may not fully develop to accurately assess all components of the model.
Auditors often use subjective assessments.
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